Costs of low-cost credit
In Part 5, we discussed how the ZIRP (zero interest rate policy) tends to artificially elevate asset prices. It acts as a sinker to economic growth. The costs associated with keeping interest rates so low don’t end here.
- At a micro level, low-cost credit encourages spending and discourages saving. In the long term, a low-interest rate regime penalizes savers because they aren’t compensated adequately for their duration. Read Must-know: A bond investor’s guide to duration for more insight into the concept of duration and how it affects the expected returns for an investor. With the zero-bound interest rates in the US, ten-year Treasury yields fell to under 3%, while money market funds are yielding less than 1%. Although existing bondholders may have benefited with interest rates being so low—bond prices rise when yields fall—those seeking to invest anew are discouraged.
- The unattractive rates offered by US Treasuries (TMV) prompt investors to turn to more risky, high-yield but less credible debt. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK) are popular funds in the US that track high-yield or junk debt. Lower short-term rates also impact money market funds’ profitability. They’re an important source of short-term working capital credit for companies.
- There’s another concern that arises from keeping rates “too little, too late,” as propounded by investment baron, Bill Gross. Read, Bill Gross on the Fed’s Rate Hike Decision: “Too Little, Too Late.” Extended periods of low-interest rates tend to lead the economy into a state of deflation. Our recent analysis on Ray Dalio and Bill Gross’ commentary discussed Ray Dalio’s belief that the growing risk of deflation is pressuring the US Fed to raise rates. Ray Dalio is the founder and CEO of the $160 billion hedge fund, Bridgewater Associates. With commodity prices falling and affecting energy firms like Chesapeake Energy (CHK) and Marathon Oil (MRO), fears of a deflationary environment have raised hopes that the Fed will raise interest rates soon. Some market commentators think that given the facts that the Fed has already bottomed out on lowering rates and the falling commodity prices continue to exert deflationary pressures in the economy, the US economy might be heading towards a Japanese-style deflationary condition. According to Ray Dalio, Japan Is Undergoing an ‘Ugly Deflationary Deleveraging.’
While Ray Dalio thinks that the Fed’s next big move will be to ease, Bill Gross believes that the Fed needs to “get off zero and get off quick.” We’ll discuss this next.